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Could Stress Tests Be Europe's Last Chance?

US TreasurySecretary Tim Geithner got what he wanted.

Friday at noon, New York time, 91 banks in Europe will reveal how strong they would be if the region went back into recession over the next two years and the sovereign debt they hold plunged in value.

In fact, smart-money players tell me the next 24 hours may represent Europe's last chance to sufficiently kick-start confidence in its banks to the extent there’s not another "blow-up" of confidence if we double-dip.

The problem is that while the tests may look like those America held in May of last year, their credibility is questionable, and they may not calm investor jitters.

Some even fear the exercise could backfire.

Importantly, the tests are being carried out by 20 different national regulators. The fear is that local conflicts of interest might jeopardize the rigor and credibility of each test, and that they will be politicized.

"It’s like asking a heroin addict if they’re still using beams." -OliveTree Securities, James Chappell

Two weeks ago, about 20 banks were expected to fail. James Chappell at OliveTree Securities told me that that number continues to fall.

"Until the last few days," he said, "the consensus has been for 10 to 15 banks to fail. But you know now, I think, we could be in single digits—and that may leave the market slightly concerned."

Put bluntly, the market "wants" some banks to fail, and, in each case, for its respective government to instantly release clear and detailed plans of where new cash will come.

For those who pass the test, the market wants total transparency on what assumptions are used to get there. Claire Kane, banks analyst at MF Global, is expecting that some banks won't make the grade. "I think it’s important that some banks fail, so that it doesn’t look like it was a complete whitewash," she said.

"Then, hopefully, if we see some good recapitalization plans, some confidence will be restored. [Then] you would play the banks that have suffered the most, so the euro-zone banks, that would be the Spanish, the Greek and the Italian."

It’s also important that none of the major, international banking names in Europe will likely be failed. Alessandro Roccati ran his own stress tests on 46 players for Macquarie Securities.

He concludes that "only small banks will fail the stress test. There is not a single name among the large caps that will fail. The positive is that there is no systemic risk in the European banking sector."

Hedge fund manager Michael Browne, at Martin Currie, said that that stands to reason. "If any bank fails these stress tests, it means that the local regulator has been doing nothing for the past two and a half years," Browne said.

He added, "European banks have been substantially recapitalized over that period, and their balance sheets cleaned up. I expect a series of good results, and a series of opportunities here."

Local bigwigs across Europe are already leaking information about which zones have passed all their local players. I'll focus on three countries.

Greece

If the "Big 4" Greek banks have really passed, then the local stress tests must have been fudged. But world markets can totally ignore it.

The Greeks are already locked out of wholesale funding with the European Central Bank's [ECB] financing 20 percent of the system. Anyway, the IMF(International Monetary Fund) will conduct its own stress tests in Greece in September as part of its €100bn bailout.

Germany

It’s said that the seven state-run German banks being tested have passed. That would not surprise me. Apparently, the Landesbanken were allowed to test themselves.

"It’s like asking a heroin addict if they’re still using beams," concluded OliveTree's Chappell. But no matter, they’re not quoted. And there’s still up to €300bn in Germany’s Soffin rescue fund to "bung" their way.

Spain

The biggest—and potentially the most positive news of all—could be that all 27 Spanish banks being tested have passed. People like Martin Currie's Browne told me to trust the regulator: "The Spanish banking system has, in all honesty, in the quoted sector, sailed through this, because the Bank of Spain is a conservative, good-quality regulator."

Presumably it must also mean that Madrid’s efforts to shore up Spain’s 19 unquoted and opaque regional savings banks, called cajas, by forcing their consolidation are paying off in their projected new balance sheets.

If there is a general re-rating of Spain, MF Global's Kane knows where to head.

"I would look to buy BBVA [Banco Bilbao Vizcaya Argentaria] and Santander [Banco Santander] , particularly BBVA which has underperformed Santander," she said. "This is because whilst they are very diversified banks, they have been treated as just Spanish institutions, heavily hit along with the Spanish IBEX and quite unwarranted in our view."

But European banks have another major problem—funding.

Banks in America and Asia fund all the loans they give customers from the deposits that receive. Here in Europe, banks lend more than they borrow—about 20 percent more. Traditionally, the banks make up the 20 percent extra lending by borrowing in the wholesale market. But no one will lend to the likes of the Greeks and some Spanish.

To prevent a Lehman-style meltdown, the ECB has therefore become a major counterparty, lending to the weak, recycling excess deposits from the strong. So, on Friday, banks need also to be persuaded that it’s time to trust each other again

"Ultimately, this is where the greatest concern exists for Europe," said Chappell. "If they don’t get this stress test right, how are they going to reopen those funding markets? Southern Europe is going to remain dependent on the ECB for funding. That's a situation that isn’t on the table in the long run."

Finally, the really good news. It appears that the French have lost their last-ditch attempt to get the release of tomorrow’s stress tests brought forward from noon ET on Friday.

Despite the fact that markets would be shut by then in Europe, Paris reportedly became incensed when it realized that US markets will be able to trade banks' ADRs [American depositary receipts] for a good four hours.

It could prove to be a profitable end to the week.

Watch CNBC for extensive, live coverage of the test results all day Friday, July 23.

Contact Europe: Economy

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